Rev. Proc. 2000-37 offers long-awaited reverse-exchange safe harbor.

• Author: Hamill, James R.
• Position: IRS procedure

EXECUTIVE SUMMARY

* In the past, some reverse exchanges failed because they were not structured as exchanges.

* Rev. Proc. 2000-37 allows some flexibility in dealings between the taxpayer and the accommodator.

* By issuing a procedure, the IRS is not necessarily saying that the safe-harbor transactions qualify as Sec. 1031 exchanges as a substantive matter, only that it will not challenge them.

Taxpayers have long used intermediaries to hold property while searching for a like-kind property to exchange and avoid gain recognition. These so-called "parking arrangements" had to be structured correctly to work as intended. In Rev. Proc. 2000-37, the IRS has now offered a safe-harbor structure that it will not challenge. This article examines the history of such arrangements, how they fared and the new provision.

Sec. 1031(a)(1) provides for nonrecognition of gain or loss when property held for investment or trade or business use is exchanged for like-kind property held for investment or trade or business use. Sec. 1031(a)(3) limits the application of Sec. 1031 to deferred exchanges; it provides that any property not both (1) identified within 45 days of transfer of the relinquished property and (2) received within the earlier of (i) 180 days of the transfer of such property or (ii) the due date of the taxpayer's return for the year of the transfer, will not qualify as like-kind property. The deferred exchange rules are a statutory codification of the rule established in Starker,(1) and apply to exchanges in which the taxpayer sells relinquished property and thereafter (or simultaneously therewith) acquires like-kind replacement property. Treasury issued final regulations that, while not complete in the eyes of many tax advisers, provide guidelines for the structure of a deferred exchange.(2)

Less clear is whether a taxpayer may first acquire replacement property, later sell relinquished property, and meet the two-step Sec. 1031 gain nonrecognition requirement. The "reverse exchange" or "reverse Starker" is not addressed in either the Code or regulations,(3) and raises a variety of troubling questions. Because tax advisers with real estate investor clients frequently encounter the reverse-exchange issue, Treasury's lack of interpretive guidance has long been a concern. Several years after the issuance of the final deferred-exchange regulations, the American Bar Association (ABA) Section of Taxation drafted suggested reverse-exchange regulations,(4) which failed to lead to Treasury initiatives. Early in 1999, Treasury officials indicated that reverse-exchange guidance was likely to be issued in some form; on Jan. 17, 2000, an informal ABA task force submitted a proposed revenue procedure to the IRS. On July 13, 2000, a similarly worded proposal followed from a small group of ABA Tax Section members.(5)

The ABA proposals have been adopted in large part in Rev. Proc. 2000-37,(6) which creates a safe harbor for certain post-Sept. 14, 2000 reverse-exchange structures. The most significant difference between the ABA proposals and the procedure is the time period in which the reverse exchange must be completed. Many taxpayers may be unable to complete all the steps within the prescribed deadline. To better understand the safe harbor (and because it does not apply to either pre-Sept. 15, 2000 arrangements or to post-Sept. 14, 2000 structures not within the safe harbor), this article begins with a review of judicial and IRS interpretations of the application of Sec. 1031 to reverse exchanges. After describing the typical pre-safe-harbor reverse-exchange arrangements and the problems encountered, the procedure's safe-harbor provisions are discussed and the merits analyzed.

Judicial and IRS Guidance

Valid Exchange

In Rutherford,(7) taxpayers entered into an agreement to receive 12 half-blood heifers. They agreed to artificially inseminate them and deliver 12 three-quarter blood heifers to the other party. The three-quarter blood heifers were delivered over three years. The Tax Court concluded that the transaction qualified as a Sec. 1031 exchange, even though the replacement property was received before the relinquished property existed. The agreement between the parties established an intent to exchange; the taxpayer could neither receive cash for the property to be transferred nor be required to pay cash if the three-quarter blood heifers could not be delivered. Instead, the other party could take back the half-blood heifers if the taxpayer failed to satisfy his obligations. Rutherford was marked by a clear intent among the parties to effectuate an exchange.

In Biggs,(8) a taxpayer listed property for sale and found a suitable buyer. Seeking to make an exchange, the taxpayer also located replacement property. Because the buyer did not want to acquire and transfer title to the replacement property, the taxpayer's attorney agreed to serve as an accommodator through a newly formed corporation. The accommodator corporation took title to the replacement property, then contracted to sell it to the buyer of the taxpayer's property; the buyer assigned the contract rights to the taxpayer. Title to the replacement property was then direct deeded to the taxpayer; two days after receipt of the replacement property, he transferred the relinquished property to the buyer. The delay between the receipt of the replacement property and the transfer of the relinquished property was only two days.

The Service argued that the transaction could not be an exchange, because the buyer never held title to the replacement property.(9) However, the transaction was an exchange, because it was clearly part of an integrated plan in which certain formalities were followed. The taxpayer could not receive cash in the exchange; the distinction between an assignment of contract rights and acquisition of legal title was not viewed as a substantive one. Because the buyer of the relinquished property was deemed (through the accommodator's assignment of contract rights) to be the transferor of the replacement property, the Biggs transaction was found to be a valid exchange.

In Letter Ruling 9814019,(10) a regulated public utility held an easement allowing it to build overhead transmission lines over another corporation's property. That corporation, which had granted the taxpayer the easement, intended to develop its property; the taxpayer's easement interfered with approval for that development. Thus, the taxpayer and the other corporation agreed to an exchange of easements; the taxpayer would receive a new easement and transfer the old easement after being satisfied that transmission lines constructed on the former were performing properly.

The Service stated that the "facts of this case present a reverse exchange transaction between two parties" that qualified under Sec. 1031. There was no discussion as to the application of Sec. 1031 to reverse exchanges, although the ruling granted implicit approval to the reverse nature of the transaction. The facts did not indicate the time lapse between the receipt of the new easement and the transfer of the old, although it may have occurred within the same tax year.(11) As with Rutherford and Biggs, there was a clear intent to effectuate an exchange between the parties.

No Exchange

The cases in which a taxpayer failed to qualify a purported reverse exchange under Sec. 1031 suffered from a lack of an exchange. In Lee,(12) a taxpayer purchased farm property in Washington from one party; seven months later, he sold property in Hawaii to others. He contended that he had exchanged the Hawaii property for the Washington property, because the proceeds of the Hawaii sale went directly to the seller of the Washington property to reduce the taxpayer's deferred payment obligation thereon. However, neither the substance nor the form of the purchase and sale transactions resembled an exchange. The documents for the two transactions did not mention each other; further, there was no evidence that the Hawaii sale was even contemplated when the Washington property was purchased.

In Bezdjian,(13) a taxpayer contracted to purchase property, then attempted to sell other property he owned. He sought to structure a two-party exchange with the seller of the new property; after being turned down, he sought a multiparty simultaneous exchange. Because the old property could not be sold before the closing date for the new property, the taxpayer borrowed funds to complete the acquisition of the latter. Within three months of purchasing the new property, the taxpayer sold the old property; the cash proceeds were transferred directly to the bank that financed the acquisition of the new property. Unlike Lee, it was clear that the taxpayer in Bezdjian had always intended to structure an exchange and that the sale of the old property was contemplated when the new property was acquired. However, the form and substance of the transaction was a purchase of one property and sale of another. There was no interdependence of the two transactions, because there was no party (e.g., an intermediary) with which the taxpayer exchanged the two properties. As was the result in Lee, the mere fact that cash proceeds from sale of the old property were used to retire debt on the new property did not evidence an exchange.

Dibsy(14) involved a fact pattern similar to Bezdjian, but arose after 1984 statutory amendments to Sec. 1031 that permitted deferred exchanges. A taxpayer contracted to sell a liquor store and purchase a larger one. When the sale of the old...